Macroeconomics

Unemployment

Natural

Cyclical

Year

Rate u

Rate u

n

Unemployment u

− u

n

1982

9.5%

6.0%

3.5%

1983

9.5

6.0

3.5

1984

7.4

6.0

1.4

1985

7.1

6.0

1.1

Total 9.5%

Unemployment During the Volcker Disinflation

TA B L E

1 3 - 1

11

Laurence Ball, “What Determines the Sacrifice Ratio?” in N. Gregory Mankiw, ed., Monetary

Policy (Chicago: University of Chicago Press, 1994).

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400

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run

The natural-rate hypothesis allows macroeconomists to study separately

short-run and long-run developments in the economy. It is one expression of the

classical dichotomy.

Some economists, however, have challenged the natural-rate hypothesis by

suggesting that aggregate demand may affect output and employment even in the

long run. They have pointed out a number of mechanisms through which reces-

sions might leave permanent scars on the economy by altering the natural rate

of unemployment. Hysteresis is the term used to describe the long-lasting influ-

ence of history on the natural rate.

A recession can have permanent effects if it changes the people who become

unemployed. For instance, workers might lose valuable job skills when unem-

ployed, lowering their ability to find a job even after the recession ends. Alter-

natively, a long period of unemployment may change an individual’s attitude

toward work and reduce his desire to find employment. In either case, the reces-

sion permanently inhibits the process of job search and raises the amount of fric-

tional unemployment.

Another way in which a recession can permanently affect the economy 

is by changing the process that determines wages. Those who become unem-

ployed may lose their influence on the wage-setting process. Unemployed

workers may lose their status as union members, for example. More general-

ly, some of the insiders in the wage-setting process become outsiders. If

the smaller group of insiders cares more about high real wages and less 

about high employment, then the recession may permanently push real 

wages farther above the equilibrium level and raise the amount of structural

unemployment.

Hysteresis remains a controversial theory. Some economists believe the the-

ory helps explain persistently high unemployment in Europe, because the rise

in European unemployment starting in the early 1980s coincided with disin-

flation but continued after inflation stabilized. Moreover, the increase in

unemployment tended to be larger for those countries that experienced the

greatest reductions in inflations, such as Ireland, Italy, and Spain. Yet there is

still no consensus on whether the hysteresis phenomenon is significant or why

it might be more pronounced in some countries than in others. (Other expla-

nations of high European unemployment, discussed in Chapter 6, give little

role to the disinflation.) If it is true, however, the theory is important, because

hysteresis greatly increases the cost of recessions. Put another way, hysteresis

raises the sacrifice ratio, because output is lost even after the period of disin-

flation is over.

12

12

Olivier J. Blanchard and Lawrence H. Summers, “Beyond the Natural Rate Hypothesis,” Amer-

ican Economic Review 78 (May 1988): 182–187; and Laurence Ball, “Disinflation and the NAIRU,”

in Christina D. Romer and David H. Romer, eds., Reducing Inflation: Motivation and Strategy (Chica-

go: University of Chicago Press, 1997), 167–185.

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